Warren Buffett, the world’s richest investor, changed the paradigms of investing when he said he was a “decades trader”. He didn’t like flipping stocks since there were transaction costs involved. His mantra was simple: invest for cash flow. Covered calls are the latest innovation that will enable you to do so with ease. Read on to find out how.
Why Invest For Cash Flow
The entire gamut of financial investing activities revolves around two simple rules:
1. A dollar today is worth more than a dollar tomorrow – Covered calls give you the premiums right away.
2. A safe dollar is worth more than a risky dollar – Covered calls are safe in most cases as we will see in scenario analysis below.
In the traditional buy and hold strategy, you only receive cash flow in the form of dividends. These dividends are paid once a year on the face value of the stock. The problem is that dividends pay a negligible amount and are paid quarterly or yearly. If you were to recover the cost of your stock purchase, it could take you 20+ years to do so.
On the other hand, when you sell a covered call, you receive a payment for every call option you write. Contracts can be written monthly or quarterly. So, if you add this to your dividend payments, the amounts become formidable. You could end up recovering your cash in five years or less, if all goes well!
Understanding The Probabilities
In finance we typically work out a series of scenarios and assign probabilities to them before we decide to invest. Let’s look at the payoffs of covered call investing in different scenarios:
Scenario 1
Rising Prices: This is the most unlikely scenario now. The Dow Jones Industrial Average was less than 9,000 points in 2010 and is over 12,000 now. This dramatic surge is unlikely to continue in the coming months. Since the equities market in the BRIC (Brazil, Russia, India, China) countries as well as the prices of commodities like gold and oil are going through the roof, experts expect money to flow out of US equities in the long run. Also, prices must rise substantially. They have to go over the price of the call premium for the buyer to exercise it.
Covered Call Payoff: When prices go up, a covered call investor makes money.
Scenario 2
Stable Prices: This scenario is moderately likely, given the present circumstances. There is a status quo prevailing in the market as investors are uncertain about what the future holds. You can see this is the straight line in the Dow Jones Industrial Average graph of the past one month. It has been range bound fluctuating between 12,050 and 12,250 points. Until there are clear clues about what the future holds, it is likely to remain so.
Covered Call Payoff: You keep the time premium, as the option (being out of the money) will not be exercised.
Scenario 3
Falling Prices: This is most likely, given the current crisis in Egypt and the Middle East. Oil prices are soaring leaving less disposable income in the hands of the consumer. The Fed is printing $2 billion daily to make coupon payments on outstanding debt devaluing the dollar. The fundamentals are weak and collapse is inevitable. But this will take time and, in the meanwhile, you can enjoy your income stream.
Covered Call Payoff: While the market bleeds, a covered call investor has some downside protection from the option he sold. It may not protect against a dramatic drop, but it will protect against the first part of any drop.
Downside Protection
Covered Call Investing is therefore buying and holding version 2.0. The newer features include making money every month and seldom losing money out of your pocket.